A. Field of the Invention
The present invention relates to managing economic risk regarding purchase from one or more suppliers of one or more components needed to produce a finished product for commercial sale. In one aspect, the invention relates to a computerized system of reducing risk relative to potentially volatile prices of components needed by a manufacturer to create finished goods for wholesale or retail sale.
B. Problems in the Art
Manufacturers of finished goods for wholesale or retail sale many times must purchase components needed to produce the finished goods from one or more suppliers. This creates economic risk for the manufacturer because the price of the components is not under direct control of the manufacturer. If the price of the components is so high that cost of production of the finished goods does not produce a profit, the manufacturer experiences economic loss.
This risk can even occur in a substantially free market. While a manufacturer can seek the lowest price for the needed components in the marketplace, sometimes the market will not bear a wholesale or retail price for the finished good that is high enough to produce a consistent profit relative to the cost of the components. Risk exists even if the price of the components change over time. Particularly in a volatile market for the component, the manufacturer may enjoy greater than normal profits when the component prices move low, but may suffer small profits or even loses on substantial price swings in the opposite direction.
These types of risk can exist even in more regulated markets. The market for components needed to manufacture ice cream as a finished product in the United States is one example.
A major component of ice cream is milk. The milk market in the United States is an example of a government regulated market.
For example, the government sets the minimum blend price that a milk handler must pay to a milk producer. The blend price is calculated using the Class prices, which are set by the National Agricultural Statistics Service (NASS) and created by surveying the wholesale prices for the finished products that are represented by each Class.
Specifically, there are four classes of milk component buyers, sometimes called classes of milk handlers:                Class I buyer/handler—buys milk to manufacture bottled milk as a finished product (typically the most expensive wholesale prices and therefore subsequent Class prices);        Class II buyer/handler—buys milk to manufacture soft dairy products, such as sour cream, ice cream, or milk cultures as a finished product;        Class III buyer/handler—buys milk to manufacture all types of cheese, cream cheese, etc. as a finished product; and        Class IV buyer/handler—buys one or more components of milk to either manufacture a finished product or sell a wholesale or retail product (e.g., powdered milk, butter) (typically the least expensive wholesale prices and therefore subsequent Class prices).        
Typically Class II volumes represent a small percent of the total of sales of all four Classes, particularly in specific regions.
One conventional way to purchase milk is from a Coop or buying the partially processed components of milk (e.g., non-fat solids and fat solids in either condensed or dry form).
Another conventional way for a Class II handler to obtain milk is to go directly to milk producers (e.g., dairy farmers) and purchase milk at or as close to the minimum regulated price as possible. Risks associated with these more conventional ways include (a) uncertainty of price, especially if the price tends to fluctuate substantially, and (b) scarcity of supply or sellers. Thus, a Class II handler under this milk purchasing schema lacks the desired predictability, and a defined cash flow model. As illustrated diagrammatically in FIG. 1A, the Class II handler must locate enough producers to acquire sufficient milk quantities at a required quality or having other specifications. There can be competition between handlers in Class II for the producer's milk, as well as competition from handlers of other Classes. Furthermore, milk is an extremely perishable commodity and is not typically found in an unbalanced supply and demand situation. Therefore, each Class II handler has uncertainty as to finding sufficient milk for its finished products, as well as uncertainty of price for the milk over time. A subtle point is there is also uncertainty (i.e., volatility) for producers. Since milk is typically the subject of a reasonably balanced supply and demand situation, changes in either the supply or demand, even locally or regionally, have significant impact on price thereby creating a high level of volatility for milk prices in the market as illustrated in the plot shown in FIG. 1A. Volatility in the regulated price presents the risk that payments from handlers for the milk will not exceed the producer's cost of production for the milk.
Class II regulated milk prices do tend to be fairly volatile. FIGS. 2A-D are a compilation of data charts showing the Class II blended minimum prices on a month-to-month basis as published by the USDA Federal Milk Marketing Order Office 30 for years 1999-2009. The Class II price is determined through the application of the % utilization of milk by Class in each Federal Market Order (based on the geographical region) times the class price. The blend price is the minimum price required to be paid to producers in the geographical region by the Federal Market Order. A producer price differential (PPD) value, such as that illustrated in FIGS. 5A-D, (which is an adjustment to the Class value of the milk) is a government calculated pay price factor that is not captured in the other components that make up the producer price (i.e., protein, butterfat, and other solids prices). There can also be a published local compensation value, such as a county adjustment, that is added (or subtracted) from the blended base and PPD sum. Note how in FIGS. 2A-D that the Class prices can move several dollars one way or the other month-to-month. The largest swings are on the order of 30-40%. This is further exemplified in the rolling 13-month correlation calculations. Note that the correlation coefficient falls below regulation standards (0.85 under FASB regulations) for 65% of the time periods shown. FIGS. 2A-D further show that if a large enough correlation window is selected it appears that you are correlated, which is not the case as evidenced by the fact that the rolling 13-month basis is not sufficiently correlated. At the margins of Class II handlers, this is considered volatile.
Techniques have been tried to reduce the economic risks of Class II handlers relative to the regulated Class II prices.
One is an old and well-known risk management tool. Class II handlers can hedge against the risk of high milk prices by: Purchasing either cash settled futures or physical Class IV components at times when prices are deemed low (so that if Class II prices go up, the Class II handler can hopefully sell its futures or stockpiled Class IV components at sufficient profit to offset lowered profit because of higher Class II prices—or use the hopefully lower price stockpiled components in manufacturing its finished products).
However, there are issues with this technique. Hedging by purchase of Class IV futures or the physical components itself has uncertainty because with the class IV hedge instruments there is a lack of market liquidity—not enough market participants to create sufficient volumes to allow price discovery and efficient markets. Class IV components can be hedged with futures instruments. Non-fat solid Class IV components can alternatively be physically bought and stored, and then resold (an exception is butter fat which can be hedged with futures). If physically bought and stored, it requires the Class II handler to physically obtain possession of the Class IV components. This involves additional costs and resources. For example, purchase of physical powdered milk requires a Class II handler to become a warehouse of the physical goods. This requires appropriate storage buildings, transportation costs, maintenance costs, and the like. Also, if the Class II handler needs to sell any or all of the stockpiled goods, the handler has to find buyers and deliver the goods to them. As a result, hedging Class II in this manner is very inefficient and not the most economically viable option.
Current regulated milk pricing does not allow for a Class II handler to price its milk to its producers in another Class (e.g., at Class III prices). In addition, the government-set producer price differential involved in Class II milk pricing is a function of equalizing the regulated Federal Milk Marketing Order (FMO) pricing structure and has too much monthly variation in it to allow a regulated Class II handler to create an effective hedge in the Class III futures, thereby forcing other types of hedges to be utilized, such as those described above. The most common type of Class II hedge, as discussed above, is the purchase of physical milk powder to hedge the non-fat solids portion of milk and the purchase of cash settled butter futures or actually buying physical butter to hedge the fat solids portion of the milk. This approach requires a great deal more cash and is subject to the deterioration of quality on physical purchases, the cost of storing the physical products, and the limited ability to efficiently buy and sell physical product in the commercial markets at timing and volumes that provide the necessary liquidity.
Therefore, there has been a long need in the industry for improvement in financial risk management associated with regulated but volatile milk component prices.
Recently, the U.S. Congress passed a Farm Bill (2008) which allows all handlers except Class Ito execute forward contracts with producers; once the contract is approved by the FMO, this allows pricing to the producer to fall below minimum blend prices as set by the FMO.
Current Federal Milk Market Order Pricing schemas require those who purchase milk direct from producers to pay producers according to minimum price regulations administered by the USDA Federal Milk Marketing Orders. However, a change to the 2008 Farm Bill allows handlers to avoid paying minimum regulated pricing, and modify other regulated terms if producers are willing to sign a contract and have it approved by the Federal Milk Marketing Order that oversees the handler.
However, even if a Class II handler gets suppliers to contract for prices below Class II minimums and gets the contracts approved, there remains no comprehensive system for managing economic price risk in this situation. If the price is too low, producers will not contract with the Class II handler, who may not be able to meet demand for its products. Notwithstanding, prices still tend to be tied to some government or regulated price minimums, and thus still have volatility. There is still no adequate solution for hedging against this kind of price volatility.
Complicating matters further are relatively recent regulations that pertain to speculative ventures and investments, including hedging and derivatives. Sarbanes-Oxley legislation and related standards (e.g., Financial Accounting Standards Board Statement 133) can affect whether certain business arrangements are deemed compliant with financial reporting and acceptable risk. This can affect whether lenders, regulators, or business partners deem the business arrangement within reasonable risk to proceed. Thus, a potential impediment to ways to reduce Class II handler risk in milk purchases is compliance with these types of standards. This can be especially true if hedging, especially with derivatives (e.g., futures and options), is involved.
The issues identified above do not only affect the profit margin of the Class II handler. They can affect the ability of the Class II handler to obtain and secure financial and other business relationships with third parties. Examples would be banks, financial lenders or other prospective business partners. The volatile regulated pricing may present unacceptable uncertainty and risk to potential partners, especially financial partners. By way of another example, it can affect relationships with customers or potential customers of the Class II handler, as potential customers may consider the volatility and risk position of the Class II handler to be inconsistent with its policies, needs or goals.
Therefore, these are other very real and substantial issues faced in the marketplace and in need of improvement.
While the foregoing issues are described in the context of Class II milk handler, similar issues can exist in other situations involving a buyer needing a component to manufacture a finished product. Examples include but are not limited to wheat for flour milling, livestock for meat processing, oil for refining, etc.